An Alternative Route to Appreciation for China’s Yuan

With China’s economy surging and flirting with a property bubble, most analysts are prescribing the same remedy: a stronger Chinese currency that would help contain inflation.

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A few economists are now turning that argument on its head, and proposing that China allow inflation to do the work of currency appreciation. Rather than adjusting the currency upward to make Chinese goods more expensive abroad, authorities should just allow rising wages and other costs to make Chinese goods more expensive, they say. To put it in the language of economists, they think China can get the needed adjustment in the real exchange rate without actually moving the nominal exchange rate.

China is under tremendous pressure from the U.S., Europe and other nations to shrink its huge trade surplus, which some blame for contributing to the financial crisis. A stronger currency could do that by making Chinese goods less competitive. But Premier Wen Jiabao and other government officials have pushed back against outside pressure on the currency. They have kept the yuan, or renminbi, fixed against the dollar since mid-2008, and a big, rapid move is widely seen as unlikely.

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Higher inflation could have the same effect—albeit indirectly—and be less contentious politically within China. If average prices in China rise 5% more than in the U.S., and the currency doesn’t move against the U.S. dollar at all, the result is effectively the same as if China revalued the yuan by 5% and the two countries had the same inflation rate. In both cases, Chinese goods have gotten 5% more expensive in U.S. dollar terms, or to put it another way, the real exchange rate has increased 5%.

“It is not clear that nominal renminbi appreciation is necessary,” Xiao Geng, director of the Brookings-Tsinghua Center for Public Policy in Beijing, writes in a recent article. The key, he argues, is to understand that some kinds of inflation are actually desirable.

As a developing country, China is on the road from being a poor nation to being a richer one. As part of that process, everything in China will get more expensive over time: as Chinese incomes and wages rise closer to global levels, it becomes more expensive to produce goods and services, and their price also rises. In other words, some inflation is unavoidable if China is to become more prosperous and its consumers are to spend more.

“Many formerly fast-growing industrializing economies, such as Japan, South Korea, Taiwan, and Hong Kong, kept inflation around 5% to 8% during their fast-growth phases as a way to make nominal wages and general price levels converge towards global standards,” Xiao says.

Arthur Kroeber, managing director of the economic research firm Dragonomics, also thinks the kind of inflation China faces is not fundamentally worrisome. “If inflation arises from rapid wage growth generated by big productivity gains in a flexible labor market, then it amounts to a perfectly normal and healthy adjustment of the real exchange rate,” he writes in a recent article.

“In our opinion allowing more domestic inflation is a better policy than an aggressive exchange-rate adjustment,” Kroeber writes. “Higher inflation is understandably a bit scary, but it is probably the best choice for China in the coming decade.”

Accepting a persistently higher level of inflation in the economy goes against decades of Western central-bank orthodoxy – not to mention the fear, deeply rooted in Chinese political culture, that soaring consumer prices could produce social unrest.

“We tend to see inflation as bad, though in fact the convergence of wages is good. We have to tolerate a reasonable amount of inflation, and learn how to operate in this environment,” Xiao says.

There’s no sign that the Chinese government is convinced by Xiao and Kroeber’s advice. Still, authorities have been adjusting key prices in the economy in recent months: the regulated prices of key inputs like water, electricity and crude oil are going up, and local governments are raising minimum wages.

And heterodox ideas about inflation are getting a broader hearing these days, as the financial crisis pushes many thinkers to re-examine conventional practices. Olivier Blanchard, chief economist of the International Monetary Fund, now thinks that even developed economies probably can tolerate a higher level of inflation they have in the past – with central banks perhaps targeting 4% a year instead of 2%.

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